Capitalization Basics for Cannabis Startups

Startup founders often become swept up in the day-to-day on early product development and business development or other matters and may forget to pay adequate attention to initial company ownership and equity rights matters. It is nonetheless essential to document all equity issuances intended in real time, including documenting founders’ capitalization as soon as possible after entity formation.  

A few reasons this is important include, without limitation, the following:

  • to ensure the founders of a company agree regarding their roles and their respective ownership in the company;
  • to affect the issuance of the equity including the payment therefor at the early stage when fair market value of the equity is low, before the company increases in value and gains assets.  This allows early executives to pay lower prices for their equity and reap the growth benefits in their equity rather than paying and acquiring equity at an increased value after the company has grown;
  • to maintain and understand the company capitalization and have it documented in a spreadsheet backed up by papered equity award documentation so companies are ready and able to provide these materials to potential investors or acquirers who usually request this in connection with diligence (investors like to model out their own potential ownership under the existing capitalization structure and to know who they need to acquire equity from to gain ownership of the company).

The above are just a few reasons why capitalization should not be overlooked at the earliest stage of business planning of a company. Often startup founders simply agree as to what percentages they each will own without papering it appropriately and this can cause more expensive corporate cleanup problems later and disagreements around what was actually initially agreed. Applicable participants in a corporation instead should sign written agreements reflecting their equity or option acquisitions, as applicable.  Those forming an LLC should enter into an operating agreement. These documents should reflect ownership and the rights and privileges of the equity interests early on, in order to avoid the risk of future disagreement.

In addition, maintaining a capitalization table (a spreadsheet of ownership or rights to ownership) and appropriate related documentation is very important not only with respect to the first founder issuances but with respect to any employees or consultants otherwise promised equity or offered equity, as well as the award agreements or other paperwork evidencing such arrangements. This is at the crux of what acquirers and investors will want to know in terms of a company, the equity comprising the valuation, who controls decision making or has other rights and privileges or preferences at the company and how that might impact the acquirer or investor transaction. Therefore, it should be very clear from looking at the equity award documentation that it “ties out” to a capitalization table (adequately backs it up) and what the rights are that accompany that equity.

At Rogoway Law Group, we advise clients regularly on how to maintain cap tables and appropriately document equity issuances (both initial issuances and ongoing issuances). Cannabis companies regularly raise a variety of questions, not only with respect to the corporate transactional side of equity issuances, but also with respect to related tax and compliance matters (e.g. with respect to tax- valuation, vesting, certain tax elections matters, and with respect to compliance- reporting of or clearance of changes of ownership in connection with licenses or permits held by cannabis entities).

We have tax, compliance and corporate advisors readily available to assist in connection with these inquiries.  Additionally, there are some great third-party resources that we can refer clients to in order to ease the challenge of cap table management and for obtaining valuation reports and other related services. We are happy to provide references to such resources in addition to working directly with our clients to assist them in staying on top of the very important management of the capitalization of the company.

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